The Rise and Fall of Enron

IN A WAY IT'S SIMPLE, IN A WAY IT'S NOT On the surface, the motives and attitudes behind decisions and events leading to Enrons eventual downfall appear simple enough: individual and collective greed born in an atmosphere of market euphoria and corporate arrogance. Hardly anyonethe company, its employees, analysts or individual investorswanted to believe the company was too good to be true. So, for a while, hardly anyone did. Many kept on buying the stock, the corporate mantra and the dream. In the meantime, the company made many high-risk deals, some of which were outside the companys typical asset risk control process. Many went sour in the early months of 2001 as Enrons stock price and debt rating imploded because of loss of investor and creditor trust. Methods the company used to disclose (or creatively obscure) its complicated financial dealings were erroneous and, in the view of some, downright deceptive. The companys lack of transparency in reporting its financial affairs, followed by financial restatements disclosing billions of dollars of omitted liabilities and losses, contributed to its demise. The whole affair happened under the watchful eye of Arthur Andersen LLP, which kept a whole floor of auditors assigned at Enron year-round. THE BEGINNING PRESAGES THE END In 1985, after federal deregulation of natural gas pipelines, Enron was born from the merger of Houston Natural Gas and InterNorth, a Nebraska pipeline company. In the process of the merger, Enron incurred massive debt and, as the result of deregulation, no longer had exclusive rights to its pipelines. In order to survive, the company had to come up with a new and innovative business strategy to generate profits and cash flow. Kenneth Lay, CEO, hired McKinsey & Co. to assist in developing Enrons business strategy. It assigned a young consultant named Jeffrey Skilling to the engagement. Skilling, who had a background in banking and asset and liability management, proposed a revolutionary solution to Enrons credit, cash and profit woes in the gas pipeline business: create a gas bank in which Enron would buy gas from a network of suppliers and sell it to a network of consumers, contractually guaranteeing both the supply and the price, charging fees for the transactions and assuming the associated risks. Thanks to the young

consultant, the company created both a new product and a new paradigm for the industrythe energy derivative. Lay was so impressed with Skillings genius that he created a new division in 1990 called Enron Finance Corp. and hired Skilling to run it. Under Skillings leadership, Enron Finance Corp. soon dominated the market for natural gas contracts, with more contacts, more access to supplies and more customers than any of its competitors. With its market power, Enron could predict future prices with great accuracy, thereby guaranteeing superior profits. THE BEST, THE BRIGHTEST AND THE DREADED PRC Skilling began to change the corporate culture of Enron to match the companys transformed image as a trading business. He set out on a quest to hire the best and brightest traders, recruiting associates from the top MBA schools in the country and competing with the largest and most prestigious investment banks for talent. In exchange for grueling schedules, Enron pampered its associates with a long list of corporate perks, including concierge services and a company gym. Skilling rewarded production with merit-based bonuses that had no cap, permitting traders to eat what they killed. One of Skillings earliest hires in 1990 was Andrew Fastow, a 29-year-old Kellogg MBA who had been working on leveraged buyouts and other complicated deals at Continental Illinois Bank in Chicago. Fastow became Skillings protg in the same way Skilling had become Lays. Fastow moved swiftly through the ranks and was promoted to chief financial officer in 1998. As Skilling oversaw the building of the companys vast trading operation, Fastow oversaw its financing by ever more complicated means. As Enrons reputation with the outside world grew, the internal culture apparently began to take a darker tone. Skilling instituted the performance review committee (PRC), which became known as the harshest employee-ranking system in the country. It was known as the 360-degree review based on the values of Enronrespect, integrity, communication and excellence (RICE). However, associates came to feel that the only real performance measure was the amount of profits they could produce. In order to achieve top ratings, everyone in the organization became instantly motivated to do deals and post earnings. Employees were regularly rated on a scale of 1 to 5, with 5s usually being fired within six months. The lower an

employees PRC score, the closer he or she got to Skilling, and the higher the score, the closer he or she got to being shown the door. Skillings division was known for replacing up to 15% of its workforce every year. Fierce internal competition prevailed and immediate gratification was prized above long-term potential. Paranoia flourished and trading contracts began to contain highly restrictive confidentiality clauses. Secrecy became the order of the day for many of the companys trading contracts, as well as its disclosures. HOW HIGH THEY FLY Coincidentally, but not inconsequentially, the U.S. economy during the 1990s was experiencing the longest bull market in its history. Enrons corporate leadership, Lay excluded, comprised mostly young people who had never experienced an extended bear market. New investment opportunities were opening up everywhere, including markets in energy futures. Wall Street demanded double-digit growth from practically every venture, and Enron was determined to deliver. In 1996 Skilling became Enrons chief operating officer. He convinced Lay the gas bank model could be applied to the market for electric energy as well. Skilling and Lay traveled widely across the country, selling the concept to the heads of power companies and to energy regulators. The company became a major political player in the United States, lobbying for deregulation of electric utilities. In 1997 Enron acquired electric utility company Portland General Electric Corp. for about $2 billion. By the end of that year, Skilling had developed the division by then known as Enron Capital and Trade Resources into the nations largest wholesale buyer and seller of natural gas and electricity. Revenue grew to $7 billion from $2 billion, and the number of employees in the division skyrocketed to more than 2,000 from 200. Using the same concept that had been so successful with the gas bank, they were ready to create a market for anything that anyone was willing to trade: futures contracts in coal, paper, steel, water and even weather. Perhaps Enrons most exciting development in the eyes of the financial world was the creation of Enron Online (EOL) in October 1999. EOL, an electronic commodities trading Web site, was significant for at least two reasons. First, Enron was a counterparty to every transaction conducted on the platform. Traders received extremely valuable information regarding the long and short parties to each trade as well as the products prices in real-time. Second,

given that Enron was either a buyer or a seller in every transaction, credit risk management was crucial and Enrons credit was the cornerstone that gave the energy community the confidence that EOL provided a safe transaction environment. EOL became an overnight success, handling $335 billion in online commodity trades in 2000. The world of technology opened up the Internet, and the IPO market for technology and broadband communications companies started to take off. In January 2000 Enron announced an ambitious plan to build a high-speed broadband telecommunications network and to trade network capacity, or bandwidth, in the same way it traded electricity or natural gas. In July of that year Enron and Blockbuster announced a deal to provide video on demand to customers throughout the world via high-speed Internet lines. As Enron poured hundreds of millions into broadband with very little return, Wall Street rewarded the strategy with as much as $40 on the stock pricea factor that would have to be discounted later when the broadband bubble burst. In August 2000 Enrons stock hit an all-time high of $90.56, and the company was being touted by Fortune and other business publications as one of the most admired and innovative companies in the world. HOW THE FRAUD HAPPENED The Enron fraud case is extremely complex. Some say Enron's demise is rooted in the fact that Jeff Skilling, then president of Enron's trading operations, convinced federal regulators to permit Enron to use an accounting method known as "mark to market." This was a technique that was previously only used by brokerage and trading companies. With mark to market accounting, the price or value of a security is recorded on a daily basis to calculate profits and losses. Using this method allowed Enron to count projected earnings from long-term energy contracts as current income. This was money that might not be collected for many years. It is thought that this technique was used to inflate revenue numbers by manipulating projections for future revenue. Use of this technique (as well as some of Enron's other questionable practices) made it difficult to see how Enron was really making money. The numbers were on the books so the stock prices remained high, but Enron wasn't paying high taxes. Robert Hermann, the company's general tax counsel at the time, was told by Skilling that their accounting method allowed Enron to make money and grow without bringing in a lot of taxable cash.

Enron had been buying any new venture that looked promising as a new profit center. Their acquisitions were growing exponentially. Enron had also been forming off balance sheet entities (LJM, LJM2, and others) to move debt off of the balance sheet and transfer risk for their other business ventures. These SPEs were also established to keep Enron's credit rating high, which was very important in their fields of business. Because the executives believed Enron's long-term stock values would remain high, they looked for ways to use the company's stock to hedge its investments in these other entities. They did this through a complex arrangement of special purpose entities they called the Raptors. The Raptors were established to cover their losses if the stocks in their start-up businesses fell. When the telecom industry suffered its first downturn, Enron suffered as well. Business analysts began trying to unravel the source of Enron's money. The Raptors would collapse if Enron stock fell below a certain point, because they were ultimately backed only by Enron stock. Accounting rules required an independent investor in order for a hedge to work, but Enron used one of their SPEs. The deals were so complex that no one could really determine what was legal and what wasn't. Eventually, the house of cards began falling. When Enron's stock began to decline, the Raptors began to decline as well. On August 14, 2001, Enron's CEO, Jeff Skilling, resigned due to "family issues." This shocked both the industry and Enron employees. In the next section we'll look at how the fraud was discovered. ENRON DISCOVERING FRAUD On August 15, Sherron Watkins, an Enron VP, wrote an anonymous letter to Ken Lay that suggested Skilling had left because of accounting improprieties and other illegal actions. She questioned Enron's accounting methods and specifically cited the Raptor transactions. Later that same month, Chung Wu, a UBS PaineWebber broker in Houston, sent an e-mail to 73 investment clients saying Enron was in trouble and advising them to consider selling their shares. Sherron Watkins then met with Ken Lay in person, adding more details to her charges. She noted that the SPEs had been controlled by Enron's CFO, Fastow, and that he and other Enron

employees had made their money and left only Enron at risk for the support of the Raptors. (The Raptor deals were written such that Enron was required to support them with its own stock.) When Enron's stock fell below a certain point, the Raptors' losses would begin to appear on Enron's financial statements. On October 16, Enron announced a third quarter loss of $618 million. During 2001, Enron's stock fell from $86 to 30 cents. On October 22, the SEC began an investigation into Enron's accounting procedures and partnerships. In November, Enron officials admitted to overstating company earnings by $57 million since 1997. Enron, or "the crooked E," filed for bankruptcy in December of 2001.